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ARM Price Discovery and Hedging (Part 2 of 2)

The following is the second part of a two part article, be sure to check out our May 2011 newsletter last month for part 1

It seems that many Secondary Marketing Managers ("SMMs") are starting to think about the possibility of higher adjustable rate mortgage ("ARM") production at some point in the not too distant future. Eventually, the yield curve will steepen to the point where longer rates (mortgage rates) will elevate to a level where ARMs look sufficiently attractive to borrowers and ARMs will gain a larger share of total originations. As this occurs, SMMs will pay more attention to ARM execution and best-effort to mandatory spreads, tripping the "hedge or not to hedge" deliberations. Lenders that develop a strategy and implement the proper analytics and workflow in advance of this industry shift will no doubt reap the benefits of early-adoption and wider spreads. In last month's part one of this article, we explained how SMM's can discover and develop mandatory ARM pricing using Z Spreads. This month we present part two of this article, which will explore the key factors SMM's should consider when calculating hedge ratios and choosing an appropriate hedging vehicle for their ARM pipelines.

Even with a price discovery mechanism in place, SMMs still need to figure out how much to hedge with what instrument, or in risk management language, loan pullthrough and loan and hedge instrument duration and convexity (hedge ratios). When hedging ARMs, the trickiest, most critical part is determining ARM loans durations. To that end, once Z Spreads have given us ARM loan program and coupon prices, we can take a page from the fixed MBS playbook of determining durations. With Fixed TBA pricing supplied from market data providers (e.g. TradeWeb) we can employ prepayment, term structure (rate) and cash flow models to derive individual security, coupon and delivery month Option Adjusted Spreads (OAS). We can do the same thing with ARMs - the only difference is that we will use Z Spreads to derive passthrough prices and ARM prepayment models and settings to derive ARM specific OASs. The specific ARM coupon OAS values can then be used to derive price curves given rate shock and consequently ARM coupon duration and convexity. Because OAS is so model dependent, (meaning that different forward rate and prepayment assumptions can generate considerably different OAS values), many traders choose to calibrate duration and convexity in their models using consensus values from the street. Once this has been done, the model can generate price curves for appropriate ARM durations by loan program and consequently duration, convexity and hedge ratios. With this capability, Lenders can determine the appropriate hedge instrument and notional to hedge ARM pipelines.

Once price curves, duration, convexity and hedge ratios are being generated, our next task is selecting the appropriate hedge instruments for ARM's. Remember the hedger's objectives: find liquid instruments - in and out with limited bid/ask, deliverable instruments (so you don't need to pair out) and limited basis risk (trades move with the same speed as what they are hedging, i.e. similar duration/convexity). Since there is no liquid TBA market for ARM securities, (ARM TBA markets tend to be one sided, over-crowded with sellers), identifying the appropriate hedge instrument for ARM positions involves a calculated risk, with originators choosing the lesser of two evils; basis risk, or liquidity risk. Liquidity risk is the risk that a security cannot be bought or sold fast enough to prevent or minimize losses. Illiquid markets typically have wide Bid/Ask spreads and/or large price movements. Basis risk is the risk that the price movement of the hedge instrument and the price movement of the hedged pipeline are imperfectly correlated, which can lead to excess losses or gains. Because of the additional risk Lenders take when hedging ARM's, hedge performance tends to have bigger swings (positive and negative) relative to Fixed-Rate positions. Below are examples of typical hedge instruments used for ARM's and the risk associated with each:

Lenders choosing to retain servicing on ARM loans or that have a separate takeout for the servicing can choose to hedge all or a portion of their ARM pipeline with either forward cash sales, or ARM MBS Securities. However, since the forward cash and ARM TBA markets are fairly illiquid, adjusting hedge coverage (i.e. pairing out of coverage) to match changing pullthrough assumptions during the lock-period can lead to excessive hedge costs. Because of this fact, many Lenders choosing to deliver ARM Pools will only hedge a portion of the pipeline with cash forwards and ARM TBA's and will choose another hedge instrument to cover the balance of the ARM pipeline, which they swap out for ARM TBA's or short-term cash sales at the time of delivery.

Lenders that have sufficient cash readily available can also consider hedging with futures instruments. Those choosing to hedge with futures need to first establish a relationship with an Introducing Broker and then set up an account with a custodian to handle the futures portfolio. Trading futures requires not only an initial outlay of cash for the initial margin, but also may require daily wire transfers for Mark-to-Market margin as futures accounts are settled at the end of each trading day. The most common ARM hedging vehicle for larger originators is interest rate swaps. However, given the balance sheet requirements to effectively hedge with interest rate swaps, many ARM hedgers choose to use bundles of Eurodollar Futures, (EDF) which trade on the Chicago Mercantile Exchange. EDFs closely mimic the LIBOR index, or in other words, Eurodollar future bundles exhibit tight correlation with like term interest rate swaps, and have high liquidity and open-interest. Hedgers sell consecutive EDF contracts term commonly referred to as an EDF Bundle, with the number of contracts matching the duration of the fixed period of the loan (e.g. Sell 3yr EDF Bundles to hedge ARM production with duration close to 3yr EDF bundles). Although EDF's are highly liquid, Lender's choosing to hedge with this instrument alone will accept more basis risk than cash forwards or ARM MBS. Additionally, EDF's lack convexity, which can lead to additional hedge cost in the right market environment.  

 Lenders that are cash sensitive, but are willing to accept more significant basis risk can choose to hedge their ARM pipeline with 15-Year Fixed MBS. Most banks do not charge initial margin for To Be Announced (TBA) MBS trading lines, though some banks have begun doing so lately. It should be noted that most Master Forward Transaction Agreements (MSFTA) contain a Mark-to-Market (MTM) provision which allows both parties to make MTM margin calls when the counterparty risk exceeds a certain threshold, so money can change hands in advance of settlement day in certain market environments. Although they are highly liquid, the correlation between 15-year TBA's and ARM's is not perfect and can lead to excessive hedge costs given greater basis risk. 15-year MBS securities do capture convexity, unlike EDF's, but they tend to have the largest basis risk of all ARM hedging vehicles. Many ARM hedgers consider using 15-year MBS in combination with other hedge instruments (ARM MBS or EDF Bundles) in order to reduce basis risk while capturing convexity.

Compass clients have observed that a mixed basket of EDF Bundles and 15-year MBS tends to be the preferred hedge for most Lenders' ARM pipelines, (excluding larger balance sheet originators who would be more inclined to us IR Swaps). This strategy provides convexity, with some basis risk. However, since EDF's and 15-year MBS are highly liquid instruments, trading in and out of them is quick and easy, and pricing is competitive (e.g. narrow Bid/Ask spreads).  

 When ARMs start to pick up market share, hedging ARM pipelines and delivering mandatory will become more practical. Even in a thinly traded market, price discovery and modeling on ARMs is possible with the right analytics. Once Lenders are confident in their valuations, they can continue to make decisions regarding what hedge instrument to use as well as to create the appropriate policies and procedures around risk tolerance, hedge execution and delivery. By planning for the future and taking the appropriate actions necessary to begin hedging ARMs now, Lenders will be at the front of the pack rather than scrambling to implement analytics, workflow and policies in catch-up mode. – Bob Gundel